UNDERSTANDING IT ALL – Inflation: how central banks can try to control it

UNDERSTANDING IT ALL – Inflation: how central banks can try to control it
UNDERSTANDING IT ALL – Inflation: how central banks can try to control it

In their toolbox, central banks have an instrument to try to control inflation: key rates. But some of its counterparts, the ECB has chosen not to touch it for the moment, arguing that the general increase in prices is only temporary.

The global economy on the verge of overheating? The boom in post-Covid global demand has precipitated the return of inflation in developed countries in recent months.

Fueled by shortages of raw materials and soaring energy prices, the rise in prices stood at 2.2% in September over one year in France, after + 1.9% in August. In the euro zone, they jumped 3.4% last month – a high since 2008 – and should increase by more than 4% by the end of the year, according to experts. A level already reached in the United States.

• Inflation and growth: the dilemma of central banks

This situation puts pressure on central banks whose primary objective is price stability. They are therefore responsible for the delicate task of containing inflation to a reasonable level without, however, slowing down economic growth.

Among the possible options, they may choose to let prices slip, at the risk of encouraging an uncontrollable inflationary spiral. In fact, when prices increase, employees are generally led to demand an increase in their remuneration, in which case company profits will be reduced, which will encourage them to increase their prices. Households will then demand a further revaluation, leading to a further increase in prices, and so on. If we are not there yet, the shortage of manpower likely to drive wages upwards in certain sectors is an additional favorable condition for the triggering of this perverse loop.

But central banks have a unique monetary policy instrument that they can use if they find the dynamics of inflation dangerous: key rates. By raising or lowering these short-term interest rates, they have the power to maintain control over the money supply in circulation.

Some have already taken the plunge in recent weeks. Starting with the central bank of Norway which raised its key rate to 0.25%. Its Czech, South Korean and New Zealand counterparts followed suit a few days later, while the Bank of England is expected to follow suit by the end of the year. A sign that the return of inflation is raising real concerns.

• What is the link between key rates and inflation?

There are three key rates set by the European Central Bank: the marginal lending rate, the rate of interest on deposits and, most importantly, the refinancing rate. It is mainly thanks to the latter that the ECB keeps control of the level of inflation.

The refinancing rate is in effect the rate at which commercial banks borrow their liquidity from central banks. To earn money, banking institutions are therefore obliged to set their own interest rates applied to the loans they grant at a level higher than that of the refinancing rate.

In other words, the higher the refinancing rate of the ECB, the higher the interest rate of European banks, and vice versa. And the higher the interest rate of banks, the lower the recourse to credit, which will reduce the money supply in circulation and help to curb inflation.

• What will the ECB do?

It is now a question of knowing what the ECB intends to do. As a reminder, the European monetary institution is aiming for an inflation target of close to 2% in the medium term. Or a threshold leaving enough margins to prevent any risk of deflation (which is often worse than inflation).

However, these famous 2% have been exceeded in recent months. This could encourage it to raise its key rate currently set at 0% to cool the economic machine. But it probably won’t. In its latest communications, the ECB made it clear that it did not intend to budge one iota, arguing that the general rise in prices was only temporary.

“The main challenge is to ensure that we do not overreact to the transitional supply shocks” linked to the Covid-19 pandemic and which have “no impact on the medium term”, declared in particular at the end of September the president of the ECB, Christine Lagarde.

This Tuesday, François Villeroy de Galhau, the Governor of the Banque de France and member of the Governing Council of the ECB, made a similar speech: “Today, there is no reason, for example, that the Central Bank European interest rate increases next year, “he told Franceinfo. And to ensure to have “clearly the conviction” that inflation “will come back below 2% by the end of next year”.

In the end, the ECB contented itself with announcing at the beginning of September the continuation at a “slightly slower” pace of its emergency pandemic asset buyback program (PEPP), with an envelope of 1850 billion euros. euros.

• What impact in the event of a rise in rates?

In the event that inflation accelerates markedly in the coming months, the ECB will no doubt be forced to review its position and revise its key rate upwards. With several more or less favorable consequences.

On the household side, the hike in the key rate would lead to an increase in bank interest rates. As a result, access to credit would be more difficult because it is more expensive, which would slow down consumption. The same pattern would apply to businesses since an increase in the cost of credit would discourage investment.

On the other hand, a rise in rates would be advantageous for savers since they would benefit from better remuneration. Remember that currently, the real return on an investment such as the Livret A paid at 0.5% is negative given the level of inflation. Clearly, the purchasing power of savers is eroding.

For states, the ECB’s rate hike could cause major difficulties, in particular for the most indebted among them who could no longer finance themselves at lower costs. “Monetary policy is stuck by these high levels of debt,” explains BFM Business Mathieu Plane, deputy director of the Analysis and Forecasting Department at OFCE. The ECB therefore “has no real interest in raising its rates, unless we are really in uncontrolled inflation”.

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